Many people consider Warren Buffett the greatest investor in history and it's not hard to understand why. According to a 2012 Yale study, Buffett's company, Berkshire Hathaway (BRK.B 1.30%), had the best risk-adjusted return of any company or mutual fund that is over 30-plus years old.
This article is meant to help you better understand how Buffett was able to beat not just the market over the last few decades, but every single money manager and chief executive in America. The good news is that according to that same Yale study, there is no magic to Buffett's investing prowess, simply consistent application of four principles: high quality, low volatility, high-yield dividend growth stocks, and a buy-and-hold investing style.
As I'll now explain there are three ways these kinds of companies can supercharge your portfolio's long-term returns and help maximize the chances of beating the market over the coming decades.
The power of high-yield dividend growth investing
The core of Buffett's success lies in the historical truth that dividends are one of the most powerful wealth building tools in the investing world. For example consider that:
- According to a 2014 study by asset management firm Colombia Management, 42% of investment returns between 1926 and 2012 were from dividends.
- According to a 2008 study by money manager Jack Gardner between 1968 and 2007 the highest yielding 100 stocks of the S&P 500 outperformed the entire index by 28.4% annually.
- According to a 2004 study by money manager Ned Davis between 1972 and 2004, high-yield dividend growth stocks were the best performing class of equities.
| Dividend Policy | Annual Return 1972-2004 |
| S&P 500 | 8.5% |
| Nondividend payers | 4.3% |
| Dividend cutters and eliminators | 5.2% |
| Dividend growers | 7.2% |
| All dividend payers | 10.1% |
| Dividend growers and initiators | 10.6% |
Source: "DIVIDENDS, METALS, AND 1960 REPLAYS," Ned Davis Research
In addition to outperforming the market, dividends, if reinvested, offer the chance to turbocharge your long-term returns:
| Company | Yield | Return since 1970 | Return since 1970 with dividend reinvestment | Beta |
| 3M | 2.20% | 6.59% | 8.52% | 1.2 |
| Johnson & Johnson | 2.60% | 8.91% | 10.48% | 0.84 |
| Procter & Gamble | 2.90% | 7.93% | 9.67% | 0.71 |
| Colgate-Palmolive | 2.20% | 9.17% | 10.80% | 0.72 |
| Wells Fargo | 2.60% | 9.77% | 11.83% | 0.86 |
| Average | 2.50% | 8.47% | 10.26% | 0.87 |
| S&P 500 | 1.91% | 7.24% | 1 |
Sources: Multpl.com, Yahoo Finance, Ycharts
Low volatility dividend growth champions like 3M (MMM 0.86%), Johnson & Johnson (JNJ 1.49%), Procter & Gamble (PG 0.54%), Colgate-Palmolive (CL 1.07%), and Wells Fargo (WFC 2.74%), have beaten the S&P 500 by 17% annually over the last 44 years without dividend reinvestment, but if you had reinvested those dividends then their already superior returns were boosted another 21%.
To put that into context, $10,000 invested into these five companies would today be worth $357,786.68 had you not reinvested dividends, but with dividend reinvestment the portfolio would be worth 105% more, $735,176.27. In other words the power of dividends would have netted you an extra $377,389.59. Yet, as powerful as dividend reinvestment has been for these world class investments there is a more powerful way to emulate Buffett by utilizing high-yield dividend growth stocks.
It's all about the cash flow reinvestment
Warren Buffett is famous for building an empire of cash flow generating companies who together add $25 billion to Berkshire's cash pile each year.
That cash is then reinvested into other opportunistic investments that can exponentially grow Berkshire's cash flows over time. This is perhaps the most powerful way that investors can utilize high-yield dividend stocks to emulate Buffett. While reinvesting dividends back into the companies that paid them, such as through a DRIP (dividend reinvestment program) is great, targeting that cash into undervalued high-quality companies is the best way I can imagine to not only increase your portfolio's total yield, but also supercharge your long-term returns.
This is especially true when the market crashes or overreacts to bad earnings and as was the case with Buffett's fourth-largest holding IBM (IBM 0.06%) after this quarter's disappointing results.
For those needing higher yields I would recommend looking at some high-quality master limited partnerships (MLPs) or offshore oil drillers such as: Kinder Morgan (KMI 3.46%), Linn Energy (LINEQ), its non-MLP equivalent LinnCo (NASDAQ: LNCO), Vanguard Natural Resources (NASDAQ: VNR), and Seadrill (SDRL). These companies/MLPs can help you emulate Buffett in two important ways.
| Company/MLP | Yield | Beta |
| Kinder Morgan Inc | 4.50% | 0.61 |
| Linn Energy | 12.10% | 0.24 |
| Vanguard Natural Resources | 10.20% | 0.74 |
| Seadrill | 17.40% | 1.47 |
| Average | 11.05% | 0.77 |
| S&P 500 | 1.91% | 1 |
Sources: Multpl.com, Yahoo Finance
First they pay high but sustainable yields, which by itself increases the chances of beating the market. Second, the dividends/distributions they pay -- sometimes, as with Linn Energy and Vanguard, on a monthly basis -- can allow you to take advantage of quality undervaluation opportunities such as during a market crash.
As Buffett says the best way to beat the market is to keep a cool head during times of panic and "be greedy when others are fearful."
That strategy requires you to have a certain amount of cash on hand to take advantage of great buying opportunities but when markets are crashing the last thing you want to be doing is selling shares. With high quality dividend/distribution payers such as those highlighted above, your cash reserves will be replenished without you having to sell a single share. Then you'll be ready to take advantage of market fear just as Buffett is famous for doing and in the process not only lock in superior yields, but also maximize the chances of beating the market in the long term.
Buy and hold is the final piece of the puzzle
Numerous studies prove that market timing doesn't work. In fact, as my Motley Fool colleague Sean Williams recently pointed out, between 1993 and 2013 missing the top 30 up days of the S&P 500 (which cannot be predicted) would have lowered your long-term returns to just 20%, or .93% annually. That's compared to a 483% return (9.22% annually) for investors who were invested the entire time.
High quality, high-yield dividend stocks can help you to stick to a "buy and hold" investment style in one key way. By changing your investment focus to maximizing your safe, sustainable income cash flows you'll avoid the psychological pitfall that cause the average investor to have underperformed the market by 4.2% annually over the last 20 years due to overtrading.
For example, when prices are crashing and others are selling in panic, you can be cheering the opportunity to be buying great high-yield names at even higher yields thus increasing your future dividend cash flows, and future investment power.
Takeaway
High-quality, high-yield dividend stocks can help you become a more Buffett-like investor and maximize the chances of building long-term income and wealth in three key ways. First, it focuses your portfolio on those equities that history has proven to perform the best over the long term. Next they generate consistent and growing cash flows that can be used to buy undervalued, high-yielding that increase your portfolio's yield. Finally, they can change your investing attitude to help you take advantage of times of market panic when the greatest investment opportunities present themselves.
